Viewpoint: Housing Finance System? Easy, Until It Crashes

Suppose you were advising policymakers in an emerging market country on how to set up a housing finance system. First, you tell them that people don't have to save much, if any, cash for a down payment, and they don't need to prove they can afford the monthly payments, either. If house prices rise, lend them more!

If the borrower cannot subsequently pay, let him walk away with no recourse to his income or assets, and qualify him again for another loan in a few years.

Concerned with payment shock when interest rates rise? Then prevent his interest rate from ever rising for 30 years, but lower it every time interest rates decline, with no penalty.

Does this system sound too unsafe for private bank lending? Tell them they can pass over their banking system and just sell all the loans. Call this silver bullet "securitization," a wondrous U.S. innovation.

Tell them they just need to set up a government-sponsored housing bank to buy most of the loans others originate, particularly those with fixed interest rates. This "housing bank" will drive down the spreads available to private deposit-funded lenders. But they don't need to budget the cost because they can just call it private. That's a really good deal because the housing bank can then kick back virtually unlimited amounts of funds to them for political activities. It's all free. Everybody wins!

Of course such a system is likely to blow up every few decades. But the beauty of it is that when it does blow up, you can blame predatory lenders, Wall Street greed and the short-sellers.

Then you can bail it out under the table. Big commercial banks and Wall Street will even pay for it if you threaten them enough with more regulation and fees.

Sound familiar?

That's the U.S. housing finance system that Fannie Mae, Freddie Mac and the United States Agency for International Development have been touting to emerging markets for decades. It produced the bubble that burst in 2007 and caused the 2008 crash of the U.S. financial system, causing a globally systemic financial crisis and precipitating a global recession.

It's the same system that was a major contributing cause of the collapse of the savings and loan industry several decades earlier. The subprime lending industry also went bankrupt in the late 1990s. But the crisis became systemic and went global this time because the U.S. government protected all the key players — the sponsored housing banks Fannie Mae and Freddie Mac, insured commercial banks and large investment banks — until they became "too big to fail," politically if not economically.

The politicians who designed the current regulatory bill would have us believe that deregulation, lack of regulatory authority and an ideologically inspired lack of regulatory fervor of past administrations was the root cause of this systemic collapse.

That regulation failed systemically to safeguard the safety and soundness of the financial system is indisputable, but this regulatory failure was politically inspired by the very same architects of the current re-regulation bill. It was moral hazard that was the system's undoing. This was mostly manifest in extreme leverage provided by trillions of dollars of debt unknowingly backed by U.S. taxpayers.

This backing was the end result of very limited Depression-era government interventions in the financial market — primarily deposit insurance and sponsored mortgage banks — that metastasized and increasingly politicized home-mortgage lending while undermining market discipline.

The structure of the politically powerful Fannie Mae and Freddie Mac was a systemic disaster waiting to happen again. The recent advent of politically powerful "too big to fail" government-insured commercial banks operating a nationwide subprime securitization machine was a new disaster ripe to happen.

Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for funds between these two unstable and unconstrained systems that populist credit policies steered toward increasingly less creditworthy home buyers. This combination created a tsunami of subprime lending that transformed the housing boom of the first half of the decade to a highly speculative bubble.

By the time the financial system finally collapsed in late 2008, bailouts and fiscal stimulus were justifiable. But convincing markets to impose market discipline because future bailouts won't be forthcoming is the most important and problematic challenge of financial reform.

So what needs to be done? Prudential regulation remains necessary so long as government-sponsored deposit insurance is maintained — which seems inevitable — along with the implied public safety net. But the prudential regulation of commercial banks needs to be depoliticized, reinvigorated and refocused exclusively on safety and soundness, with greater reliance on market discipline where public regulation is most likely to fail because of inherent incentive conflicts. This means sound credit underwriting and more capital, closing the off-balance-sheet loopholes typically employed by big banks.

In addition, firms that are "too big to fail" are too big to be effectively controlled by regulators without political interference and should either be broken up or otherwise prevented from engaging in risky financial or political activities.

Most importantly, the two main sources of "too big to fail" systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose.

The excess investor demand for fixed-income securities backed by fixed-rate mortgages that fueled their early growth is now saturated by Ginnie Mae securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. They should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

What's been proposed so far is more regulation expanding the umbrella of protection and leading to more moral hazard.

Charging all banks (or worse, taxpayers) a $20 billion fee or tax subsidizes risk takers and makes the next systemic crisis even more likely.

If it is anything like this one, the economic costs will be about 1,000 times greater than that. Politicians will call it an "unintended consequence" of their intervention.